Over the last few months, we have written about a number of topics which are all coming together.
We noted how markets were pricing in utopia, i.e. a no landing and a Fed pivot, and we outlined that both happening simultaneously seemed unlikely. This is reflected in the chart below, which is what markets expect Fed rates to be in July. Markets struggled to digest the repricing in August and September. However, this was followed by a very stable period for expectations, part of the utopian pricing, only to be followed by an aggressive re-pricing higher since the start of February. Certainly, markets feel a lot less utopian now, as they look to interpret what higher rates mean.
Future implied rate for Fed Funds, July 2023 meeting
Source: Bloomberg data from 08.08.2022 to 27.02.2023. Past performance is not a reliable indicator of future returns.
Indeed, we have also written about our base case which has been “higher for longer” for rates and inflation. A major part of this recent repricing is that services inflation and the labour market have proved very resilient, while the Fed, obediently data dependent, have been consistently hawkish. It seemed too optimistic to assume that inflation would simply fall back to 2%, and remain there. We see structural inflationary pressures, such as deglobalisation, supply constraints within resources and looser fiscal policy as important drivers in keeping inflation stickier.
We have also written extensively about how higher inflation confuses the traditional approach to portfolio construction, with bonds no longer acting as diversifiers to equities. This has been the case for an extended period now, after bonds consistently diversified in the previous two decades. Interestingly, during the three periods illustrated in the above chart, despite markets struggling, bouncing back and then struggling, equites and bonds have remained consistently positively correlated. Indeed, financial markets generally have been correlated, with the notable exception of oil, which has been moving to its own drumbeat, and the US dollar. Even with the US dollar, correlations have been pretty consistent over those three very different periods, albeit consistently negative, i.e. a stronger US dollar has been consistent with weaker financial markets, and vice versa.
That the cost of capital has increased at the fastest rate for forty years is a sobering dynamic for financial markets and economies. Crucial is how long rates remain higher. Ultimately, though, just as an alcoholic takes their first positive step in admitting their problem, so markets are surely on a better footing now that they are being more realistic as to what they face.